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October 04, 2006

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Normally, simple is better; however, I think that you can not ignore the tax implications in this case. The "tax optics" (at least in the U.S.) favor options. This is due to the fact that restricted stock is taxed as compensation once the restrictions disappear. Options, on the other hand, have no tax consequences until they are exercised. Making employees pay taxes on private stock is dangerous since, as you say, the value of private stock is rather loose. The fact that an employee might pay taxes on private stock that could turn out to be worthless if the start-up fails is not a good situation. With options, on the other hand, the employee can avoid taxes until the options have some definite value (such as when a liquidity event like an IPO or merger occurs).

The one thing I never heard with all the expensing of options hullabaloo is how companies are supposed to value them. What impact do cliffs and vesting have on a Black/Scholes valuation? Are there agreed upon formulas for valuing vesting options?

I've got to agree with my co-Matt here.

In an early stage startup, if you're handing out equity as compensation, you should at the very least not be asking your people to chip in out of their own pocket (or, more accurately, their families' pockets, since they're not going to have any cash) to the IRS for it.

Yes, blame the IRS for counting as "income" something like restricted shares in a private company, that you can't possibly convert into rent and food. But in lieu of changing the law (which would be tough, since politicians and most voters confuse the possibility of getting rich in the future with the fact of actually being rich today) I count it as immoral to load employees down with extra tax obligations before you're able to pay them real money, and call it "compensation".

pwb,

Q: What impact do cliffs and vesting have on a Black/Scholes valuation?

A: Intuitively, they should decrease the valuation because every restriction makes the options less valuable to the holder. One simple way to model a vesting option under Black/Scholes is to replace the option grant date with the date of vesting. This would effectively shrink the lifespan of the option and thereby make it less valuable.

Q: Are there agreed upon formulas for valuing vesting options?

A: I don't think so. Anyway, Black/Scholes option pricing models make more sense when there is a public market for the stock underlying the option. In a private company, option pricing is more of an art form.

It is my understanding one way around the tax issues with restricted shares is to offer Restricted Vesting UNITS of later to be created shares. This is how Microsoft does it... and you know they get great tax advice!

As for being a straight shooter from the start "optics"... I'm with Rick on this one. Vesting restricted shares are dare I say intuitive!

BTW: Hello Rick & Toronto Venture Folks - I just moved up here and am excited about contributing to the community.

I'm in a management position. Many months ago I was given 5400 units (whatever that means) for $60,000.
I didn't have the $60,000 so a third party stepped in who was not part of the company. He then has charged me $435 per week interest on the loan. Last week the company merged with another already publicly traded company who's stock is around 9 cents per share since the merger. Up only about a penny. My questions are: What do these units now mean to me? What is a private sale? How do I take care of this $60,000 loan since I'm broke? HELP!

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